Search form

Happy Returns: How the Working Poor Got Tax Relief

Once an obscure tax loophole, the Earned Income Tax Credit has achieved policy stardom in recent years. While many programs for the poor have been ravaged over the last decade in the name of political and fiscal temperance, the EITC has prospered. Its annual cost rose from $2 billion to $12 billion between 1980 and 1992. And the 1993 budget agreement expands the program by some $20 billion over five years—:even as it cuts billions of dollars from middle-class programs like Medicare and federal employee pensions. The EITC has ardent supporters across the political spectrum, and both Democrats and Republicans have claimed it as their own.

The most obvious reason for the EITC's bipartisan popularity is its consistency with basic American values. Because benefits go only to people who work for wages, the EITC reinforces the work ethic. Moreover, it appears consistent with the ideal of limited government; there is no need for social service bureaucracies since individuals determine their eligibility and benefits themselves when they fill out their yearly tax form. A refundable tax credit, the EITC will for most recipients not only offset the income taxes they would otherwise owe but also entitle them to a rebate check. In 1994, the combined value of the tax offset and rebate check will average about $860 per family.

The Escalating EITC

The value of the EITC varies by income and, since 1991, slightly by family size. In 1993, for families with two or more children and adjusted gross income between $7,760 and $12,210, the maximum credit was $1,511; for families with one child, the credit was $1,434. (Most recipients receive their credit as an annual lump-sum benefit, but a few use the advance payment option, which provides a small but steady stream of cash benefits.) A family of four gained almost 20 cents in EITC benefit for every dollar it earned up to $7,760; it enjoyed the same credit for earnings up to $12,210; and it lost 14 cents in EITC benefit for every dollar earned above $12,210. The benefit phased out completely at $23,020 in earnings.

The 1993 budget agreement will substantially increase the maximum value of the credit (to $3370) and extend the phase-out range to around $27,000 for families with two or more children. Families with only one child will receive a much smaller increase. The budget will also create for the first time a small (up to $300) tax credit for workers who have no children and earn less than 59,000 per year.

In 1993, about 14 million families received the EITC. With the budget changes, by 1998 a couple million more recipients will be added, and the cost of the program will rise by nearly 50 percent, to roughly $20 billion per year.

The EITC has received an additional boost in recent years from two directions. Politicians from both parties "discovered" the working poor in the early 1980s and began to compete for their votes. Diverse politicians have also learned to capitalize on the program's inherent ambiguity. Because the EITC is an open-ended cash transfer, proponents have been able to portray it as a solution to any number of problems affecting the working poor, ranging from high payroll taxes to low wages to inadequate child care.

Whenever left and right are this enthusiastic about the same program, it invites close scrutiny. How did the EITC become so popular? Is it really a boon to the working poor?

HUMBLE ORIGINS

What started out in 1975 as a footnote to an unremarkable tax bill has become the federal government's largest income transfer to the poor, larger even than its share of Aid to Families with Dependent Children (AFDC). The EITC was born out of the welfare debates in the late 1960s and early 1970s. The program's creator, Democratic Senator Russell Long of Louisiana, had throughout his career used the tax code to make social and economic policy, a natural inclination for someone with jurisdiction over taxing and not spending. In the early 197Os, as the powerful chairman of the Senate Finance Committee, Long led a group of congressional conservatives and moderates who felt the Nixon administration's proposed Family Assistance Plan (FAP) was too generous. In particular, they opposed its guarantee of an annual income to all families with children, regardless of whether the parents worked, on the grounds that it would discourage recipients from working.

But FAP also contained a wage supplement for the working poor, and in his alternative proposal Long emphasized the theme of the government's responsibility to help the working poor. In 1972, his workfare bill included a "work bonus," a tax rebate equal to 10 percent of wages, available to heads of households with children and a family income under $4,000 (roughly the poverty line for a family of four). Incorporated in the Senate's version of welfare reform, the proposal died in Congress that year, as did FAP.

After 1974, Long changed his strategy. Instead of pitching his initiative as welfare reform, he emphasized tax relief. His work bonus would reduce the tax burdens of low-income workers, which had risen in recent years with increases in regressive payroll taxes for Social Security and Medicare.

After a dispute with Oregon Democrat Al Ulhnan, the new chairman of the House Ways and Means Committee, over whether to cover all low-income workers or only parents of dependent children, Long's narrower version prevailed in conference. Long dominated the House-Senate conference committee primarily because of the institutional disarray in the House. The winds of reform that shook Congress in the late 1960s and early 1970s hit Ways and Means particularly hard, peaking in 1974-75. Further, the ouster of Wilbur Mills as Ways and Means chairman in a sex scandal a year earlier had eroded the committee's expertise in tax matters and its bargaining clout with the Senate Finance Committee. Long's version of the EITC passed easily and quietly into law as a small part of the Tax Reduction Act of 1975.

EITC AS TAX REFORM

The EITC program remained relatively obscure for almost a decade and actually declined in value. The election of Ronald Reagan in 1980, however, set in motion a series of events that changed the EITC's trajectory dramatically.

One immediate consequence of Reagan's victory was that Democrats and Republicans began competing in earnest for the votes of the working poor, who overlapped with the much publicized Reagan Democrats. Voters earning between $12,000 and $25,000 (a fair approximation of the working poor) comprised about one-fifth of the electorate, and their party affiliation shifted back and forth during the 1980s. Cementing their support could mean the difference between a successful or failed Republican realignment. The defection of Reagan Democrats also provoked considerable soul-searching within the Democratic Party After doing their best to imitate Republicans in 1981, Democrats began to stress "fairness" in the early 198Os, highlighting the inequities of Reagan's spending and tax cuts.

Buoyed by victories in the 1982 congressional elections, Democrats continued to stress fairness in the mid-1980s. Increasingly they emphasized inequities in the tax code, since spending increases were blocked politically Led by Representative Charles Rangel of New York, several Democratic members of the House Ways and Means Committee and committee staff encouraged interest groups to shift their lobbying efforts from spending to taxation, and in particular praised the Earned Income Tax Credit. Given the difficulty of increasing direct spending, advocacy groups for the poor, led by the Center on Budget and Policy Priorities, began to push for expansion of the EITC.

Party competition over the working poor, the fairness issue, and the EITC converged during debates over tax reform between 1984 and 1986. Republican strategists, fearing that Mondale and the Democrats would make tax fairness a main theme of the 1984 elections, launched a preemptive strike in January that year, President Reagan announced in his State of the Union address that the Treasury would conduct a major study of tax reform. That move, coupled with economic recovery and Democratic blunders, helped minimize tax reform and fairness as campaign issues. Although Reagan won in a landslide, his earlier directive to the Treasury unleashed an unexpected torrent of tax reform activity. Its study, known as Treasury I, proposed a dramatic overhaul of the tax code. The centerpiece was a call for dramatically lower tax rates offset by sizable reductions in tax loopholes.

Two years later, Treasury I became the Tax Reform Act of 1986. (For full accounts of its evolution, see Jeffrey Birnbaum and Alan Murray's Showdown at Gucci Gulch; and Timothy Conlan, Margaret Wrightson, and David Beam's Taxing Choices.) Democrats and Republicans vied for credit for the legislation, which reduced tax rates on working and middle-class voters, indexed future benefits to inflation, and substantially expanded the EITC. Indeed, interviews with key participants suggest that the EITC was part of the glue that held the entire tax reform package together. Expanding the EITC enabled legislators to preserve or expand tax benefits for the affluent and still produce an overall package that was distributionally neutral. Policymakers learned that you could be a staunch friend of the rich and still love the EITC.

EVERYBODY'S FAVORITE PROGRAM

The EITC continued to grow throughout the 1980s as politicians discovered its broad appeal. Indeed, one measure of EITC's popularity is the disparate policy objectives politicians have enlisted it to serve.

Several congressional Democrats, for instance, proposed expanding the EITC as part of comprehensive welfare reform, in what eventually became the Family Security Act of 1988. Their idea was less to keep working poor families out of poverty than to make work pay for families on AFDC. They dropped their plans when substantially similar changes were included in the Tax Reform Act.

The EITC next surfaced in debates over the minimum wage. After Democrats retook the Senate in 1986, several liberals proposed a substantial increase in the minimum wage, which had declined in value by 25 percent since 1981. Thomas Petri of Minnesota, the ranking minority member of the House subcommittee on labor standards, countered with a smaller increase in the minimum wage and a fairly large in-crease in the EITC. Petri and other moderate Republicans managed to insert a plank to that effect in the 1988 party platform.

Things got interesting when the Democratic Leadership Council jumped on the EITC bandwagon. The DLC, formed in 1985 in the wake of Mondale's defeat, sought to wrest the party from traditionally liberal policies and constituencies. In the view of DLC members, increasing the minimum wage sent the wrong message to "mainstream" voters. Such a move tied the party to organized labor, antagonized business, was economically inefficient, and left many of the working poor in poverty. DLC members joined congressional Republicans in advocating a smaller increase in the minimum wage and a large increase in the EITC.

Divisions between the parties, among Democrats, and between Congress and the Bush White House ultimately forced policymakers to drop the EITC from the minimum wage bill. In the process, however, it became the favorite alternative to a higher minimum wage: it counted among its supporters congressional Republicans, moderate and conservative Democrats, high-ranking administration officials, and the U.S. Chamber of Commerce: Given such broad support, the question became not whether the EITC would be expanded again but when and by how much.

Much as Democrats and Republicans competed earlier over fairness and tax reform, both fought to be viewed as the pro-family party Though Reagan invoked "family values" during his 1980 campaign and subsequent presidency, the administration's emphasis on abortion and school prayer enabled Democrats to redefine the issue. They stressed the economic plight of working families.

One battleground of family policy was child care. A 1988 Gallup poll revealed that 39 percent of respondents wanted child care to be a top priority of the next administration. The trick for policymakers—:faced with divided government and widening cleavages within the Democratic Party—:was to devise a solution that would respond to these concerns and generate bipartisan support.

The central legislative debate was over the Act for Better Child Care, introduced in 1988. The debate involved three highly contentious issues: the propriety of government subsidies to church-run or church-affiliated day care centers; quality standards for day care centers; and the right mix of spending and tax expenditures for child care. Democratic members of the Education and Labor committee, backed by liberal groups like the Children's Defense Fund, Insisted that tax breaks would make child care more affordable for the middle class but not the poor. The government, they argued, should spend money directly on poor families with children (principally via expansion of the Title XX day care program) and impose regulations to ensure that those children received quality care.

DLC Democrats, on the other hand, wanted the party to stop throwing money at old programs and regulating business so heavily, a view echoed by Republicans. They proposed fewer regulations and argued for spending $9 through the tax code for every $1 spent on Title XX. Most of these tax benefits would come in the form of an expanded EITC. Working-poor parents would then have the freedom to choose between staying at home to care for their children or paying someone else to do it; they would not be forced into government-run day care.

Key liberal Democrats—:particularly Tom Downey of New York and George Miller of California—:broke the logjam by endorsing greater reliance on tax credits over direct spending. (Not surprisingly, Downey was chairman of the House Ways and Means Human Resources subcommittee; like Russell Long years before, Downey was better able to influence social policy through the tax code than through traditional appropriations.)

Legislators finally agreed on a package that included about $15 billion in tax credits and $4 billion in additional direct spending, spread over several years. Although most of the increase went to the EITC, policy-makers also created two related tax expenditures: a tax credit for health insurance for the children of working poor parents and a tax credit for families with children under one year of age. Eligibility requirements for these two new credits and the EITC were linked so that receipt of one would reduce benefits from the others. These changes were incorporated not in a child care bill but as part of the 1990 budget accord. As in 1986, policymakers used increases in the EITC to improve the progressivity of a larger tax bill.

The EITC was again an effective tool for compromise during the 1993 budget agreement. Candidate Clinton had promised health reform, deficit reduction, and investment in human and physical infrastructure. But President Clinton quickly discovered that congressional Democrats were wary of the "tax and spend" label. The solution: an increased EITC. Even though it was a sizable tax expenditure, it was not perceived as "spending." Clinton still had to compromise, principally by changing the goal from lifting every family with one wage earner out of poverty to lifting every family of four. But few in Congress could argue with the idea of making work pay for a large number of families.

The beauty of including the EITC in the deficit reduction package was that it simultaneously offered the working poor some tangible financial help and made the tax side of the package more progressive. The larger EITC more than compensated for increased gasoline taxes among individuals in the lowest tax brackets. It also benefited more households than were affected by increased income taxes, a key consideration for any legislator. Tax relief, tax fairness—:the ambiguity of the program once again served it well.

WHAT'S NOT TO LIKE?

By 1993 the Earned Income Tax Credit had achieved broad bipartisan support in Washington, a precious commodity in an era of weak parties and often polarized rhetoric surrounding social policy. The program has friends in high places, particularly Bill Clinton; David Ellwood, an assistant secretary of Health and Human Services; key members of the Senate Finance and House Ways and Means committees; and Robert Greenstein, director of the Center on Budget and Policy Priorities and a widely respected expert on social policy. Over the last decade, this support has translated into continual expansion in the face of persistent budget deficits, cuts in traditional forms of public assistance, and demands for cuts in middle-class entitlements.

The question remains, however, whether the EITC is good policy. The most common criticism of the program is that it has been deceptively hard to administer. Like many tax expenditures, the EITC isn't literally self-executing. Rather, it shifts the burden of administration from government to individuals. The working poor must somehow find out about the program, determine whether they are eligible, and calculate their benefit. None of these steps is easy for people who often lack the formal education and access to professional tax help that is often needed to make sense of the U.S. tax code.

Fortunately, these administrative hurdles have been lowered in recent years. Since 1986, many of the working poor no longer must submit annual tax returns. That is the good news. The bad news is that these changes complicated efforts to make the working poor aware of the program and the possibility of a tax refund. The Treasury and IRS are not really in the business of publicizing tax loopholes or administering social programs; their main mission is to collect revenue.

While government officials have made an effort to heighten public awareness, a more complete campaign was initiated by the Center on Budget and Policy Priorities in the late 1980s. The center has developed a standard information kit, in English and in Spanish, which it distributes to local welfare agencies, churches, unions, businesses, and community groups. (The Center also has EITC fliers in Vietnamese, Chinese, Creole, Russian, and several other languages.) The kit provides technical information about the EITC and suggestions for community-based outreach strategies. It also tells people how to contact the nearest Volunteer Income Tax Assistance office for free help in preparing tax returns.

Other organizations like the National Women's Law Center and the National Law Center on Homelessness and Poverty have targeted child care centers and homeless shelters in order to increase awareness of the program. At the local level, numerous public, nonprofit, and for-profit organizations have sponsored often creative promotional drives and free tax clinics. Nevertheless, public awareness is not enough. For a number of years, those people who knew about the EITC found it difficult to apply for benefits. Part of the problem was repeated changes to the definitions of eligible families and income thresholds. These rules were simplified in 1990, and IRS officials report that error rates for the EITC have dropped substantially But the chief culprit was linking eligibility and benefit levels to the child health insurance and young child tax credits, initiated in 1990. The idea behind linkage was to prevent the working poor from "double dipping," from getting too many tax benefits for the same needs. In the process, policymakers made the calculations so complicated that the IRS had to create a separate tax form, Schedule EIC.

Advocates realized almost immediately that a separate tax schedule might discourage people from applying and create errors in the returns of those who did apply. The New York Times, an ardent supporter of the program, called these new rules "numbingly complex." Potential recipients had to determine if they had a qualifying child, if that child met age and residency tests, if their family income fell below the adjusted gross income threshold, if they had certain forms of nontaxable earned income (for example, military housing), how much they paid for child care, and how much they paid for child health insurance. The one group who seems to have benefited from this complexity was unscrupulous insurance sales people, who deceived a number of people into buying health insurance under the false pretext that the EITC and related tax credits would cover the cost of their premiums.

One important but little noted provision of the 1993 budget accord was elimination of the two supplemental tax credits linked to the EITC. This change should make claiming the credit much easier, and perhaps even allow the IRS to eliminate Schedule EIC and reincorporate the EITC as a single line on the 1040 and 1040A forms. It should also help to boost the EITC participation rate, currently estimated at a respectable 80 to 90 percent.

more vexing problem of administration is how few recipients (less than 1 percent) take advantage of the advance payment option. To use this option, workers must fill out a W-5 form with their employers, comparable in length and complexity to the W-4 form. Considering how routinely strapped for cash the working poor are, policymakers have wondered why more people don't receive the credit as part of their regular paycheck Furthermore, economists believe that advance payment creates better work incentives than a lump sum benefit several months later.

In 1991 the General Accounting Office conducted a study of low-wage workers and employers to determine why advance payment was so unpopular. The GAO discovered that many employers were simply unaware of the option; the IRS had alerted them to the EITC but not to advance payment. Consequently, they hadn't encouraged their employees to apply for advance payment. Other employers with a large number of part-time workers found it burdensome. to recalculate the EITC advance payment every time their employees' hours fluctuated. They felt they were spending too much time and energy administering a public program.

More surprising were the reasons cited by low-wage workers. Many of them also claimed to be unaware of the advance payment option. A subsequent Gallup poll has found that fewer than one in ten EITC applicants know about the option. But others surveyed by the GAO expressed a clear preference for the lump-sum benefit at the end of the tax year. One reason cited was that workers feared receiving too large a credit during the year, owing money on the annual return, and not having enough money to pay the IRS. Their view was better safe than sorry.

This problem was also addressed in the 1993 budget accord. Beginning in 1994, eligible workers can receive no more than 60 percent of their EITC benefits via advance payment, and the rest when they file their tax return at the end of the year. This way, the working poor won't have to worry about owing Uncle Sam.

A more recent line of criticism concerns basic issues of program design and policy objectives. Some conservatives have be-come troubled of late by how many millions of people who are not technically "poor have been added to the program. For example, a family of four earning 150 percent of the poverty line could claim the EITC in 1993, and that figure will increase by 1998. The country cannot afford, detractors argue, another broad-based entitlement.

There is talk of lowering the income threshold and targeting more of the funds exclusively to families below or very close to the poverty line. Such a change should be resisted on several grounds. First, the poverty line is too low a target; people who work hard ought to live better than that line allows. (See John E. Schwarz and Thomas J. Volgy's "Social Support for Self-Reliance," TAP Spring 1992.) Second, shortening the phase-out range could create work disincentives unless the maximum benefit were reduced as well (which would limit its ability to move people out of poverty). Otherwise, EITC recipients would be penalized mom than the current 14 cents for every additional dollar they earned in 1993. While we know little about the precise effects this current penalty has on work effort, it stands to reason that the effect would be greater the faster the credit is phased out.

Finally, shrinking the client base would compromise one of the program's chief political assets—:the fact that it benefits large numbers of working poor, whites as well as blacks. The EITC lacks an organized lobby of beneficiaries and third-party providers. The last thing the program needs politically is for its clientele to resemble that of AFDC and other "welfare" programs.

Still, the underlying message about fiscal limits and the need for policy trade-offs is well-taken. As Clinton's current budget proposal demonstrates, spending programs are coming under closer scrutiny, and many of them are being singled out for reduction or elimination. Assuming that policymakers continue to agree to help the working poor, they will come under greater pressure to justify maintaining or expanding the EITC.

Is the EITC the best way to transfer some $14 billion annually to the working poor? Unfortunately, the government has not sponsored any formal evaluation of the EITC's effectiveness, and studies of the effectiveness of alternative programs (the minimum wage, for example) have sometimes produced conflicting results. The EITC is not alone in this regard: we know precious little about the effectiveness of most tax expenditures.

One can imagine several potentially useful comparisons. Perhaps the most obvious is to a higher minimum wage, which could be even simpler to administer than the EITC. The working poor would automatically receive more income, which would come throughout the year instead of in a lump sum at tax time. The fiscal cost of raising workers' wages would be shifted from the government to employers, thereby freeing up money for other programs.

Alternatively, we could subsidize the working poor directly, through European-style family allowances, rather than indirectly through the tax code. That way, recipients wouldn't have to deal with complicated tax forms, and the IRS would have one less social program to administer. Conceivably, the added simplicity could increase participation rates and decrease error rates. The national government is particularly adept at cutting checks (witness Social Security), so the cost of administering family allowances should be fairly small. And the tax code would have one less loophole, which most economists would favor as sound tax policy.

Finally, one might want to devote more resources to programs that use government subsidies not just to supplement in-come but to create better paying jobs or improve job skills. If trends over the last two decades continue, the working poor will face stagnant wages and declining opportunities for advancement. Down the road, there could be charges of "EITC dependency" Selective investments in industry and human capital could make the EITC more a transitional program, serving working people on their way up the wage and occupational ladders.

Clearly, one could support both the EITC and one or more of these alternative approaches to raising the incomes of the working poor. For example, the Clinton ad-ministration and the Center on Budget and Policy Priorities favor expanding the EITC and indexing the minimum wage. They argue that a higher minimum wage would help those working poor without children who were excluded from the EITC program until this year and who are scheduled to receive a much smaller benefit than families with children.

It is hard to say which combination of these and other programs will prove most effective in helping the working poor. However, people who believe the EITC is good policy doubtless will be pressed to explain why in more concrete terms. No question-the EITC program has provided substantial relief to a segment of the population too long ignored by social policy, Proponents now need to consolidate their gains by defining more sharply what the EITC is supposed to accomplish, continuing to lower administrative hurdles, documenting the EITC's impact, and explaining the program's virtues not only in Washington but to the general public as well.